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A Tale Of Two Stress Tests

by | Dec 12, 2018

In this blog we compare and explain the recent contrasting results of the European Banking Authority (EBA) and Bank of England (BoE) stress tests.

In early November the EBA concluded that three of the five worst performers (measured by deterioration in capital) were UK banks. By contrast, in late November the BoE determined that UK banks are all well-positioned (to varying degrees) with regards capital provisioning.

Who to believe?

Figures 1 and 2 show capital ratios by bank at the start (2017) and end (2020) of the EBA stress test scenario. Although none of the banks tested reached critical capital levels (regarded as 5.5%), it was concerning to see UK banks Barclays, RBS and Lloyds accounting for three out of the top five biggest deteriorations in capital, performing worse even than Italian banks. Barclays and Lloyds ended up with the lowest and third lowest capital ratios respectively.

The main driver of this poor relative performance is the economic scenario assumed by the EBA for the UK relative to the other geographies tested. The economic shocks imposed on each economy were not homogenous across the 15 regions tested, as Figures 3-4 show. The UK is tested against a significantly harsher economic scenario than most other countries, with the EBA imposing severely recessionary shocks on the UK including a 3% fall in GDP in the first year alone, and a 29% drop in commercial real estate capital values.

In addition, methodologies differ: the BoE includes mitigating measures that banks would use to shore up their capital position when under stress, while the EBA does not, arguably making the BoE test the more realistic test of resilience.

For certain, traders weren’t fooled: a glance at comparable corporate bond spreads shows that the market has consistently been of the view that UK banks are far safer and more sustainable institutions than their Italian counterparts, as shown in Figure 6. Taleb’s “don’t tell me what you think, show me your portfolio” test finds firmly in the BoE’s favour.

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